Is the 4% rule still 'safe' for retirement planning?
CHICAGO – Think your client’s most expensive purchase is their house? Think again. It’s retirement — and none of us really knows how much it will cost them.
Try as we might to forecast the expense, it’s only getting harder. Morningstar’s head of retirement research, David Blanchett, starts with the 4% rule, but even that’s not failsafe. Blanchett notes historic returns supported that rule (in which a client can spend down 4% of a portfolio each year, increasing with inflation). But stock valuations are currently high and, along with many others, he forecasts lower returns for stocks, especially over the next 10 years. Those nearing retirement are most at risk.
Offsetting these lower stock returns, Blanchett states real spending declines between ages 70-90 as clients slow down and spend less. Also, fixed expenditures have real inflation-adjusted declines. Yet life expectancies continue to increase, especially for the wealthy. A wealthier 65-year old couple has a 40% probability that at least one will live to age 95 or beyond. Healthcare expenditures are rising significantly faster than inflation.
So I asked Blanchett the question — is 4% safe? I thought he was going to say no, but the answer surprised me. If half of one’s income is guaranteed (Social Security or pension), and half of expenditures are discretionary, Blanchett sticks with the 4% rule when with using a 50% stock and 50% bond portfolio. However, this means one must cut those discretionary expenses when times are bad. If 25% of income is guaranteed and 25% of expenditures are non-discretionary, the safe spend rate drops to 3.5%. If only 5% of income is guaranteed, safe spend rates decline to a dismal 2% to 2.4%, depending on how much spending is discretionary.
I generally concur with Blanchett. My modeling shows that a portfolio of 50% stocks and 50% bonds has a 90% probability of lasting 25 year as long as the client’s portfolio plays the perfect game of minimizing expenses and emotions. That means rebalancing relentlessly, which is not always an easy task. In fact, a fair amount of data demonstrates that even advisors time the market poorly. Because life expectancies are often more than 25 years, consider lowering to 3%. Understand that my calculations are based upon how much one spends beyond Social Security. And I’ve found that clients initially spend more in retirement than when they worked as they have more time to travel and do other activities that costs money.
As for discretionary spending, I advise clients to cut spending if the portfolio is underperforming but that doesn’t mean they should increase the spend rate today. None of us plays that perfect game in investing, so temporarily cutting expenses may offset the investment mistakes. I asked Blanchett about investment fees and he responded that they are incredibly important noting, “if you’re paying 1% a year on $1 million that’s $10,000 you could either spend on a vacation or to use to pay an investment manager.”
I challenged Blanchett about risks such as Medicare being cut, possibly through means testing. He agreed that this was a risk and that it would be okay to show clients’ spending keeping up with inflation.
Blanchett recommends annuities for guaranteed income and I entirely agree. He stated the best place for guaranteed income today is Social Security. I tell clients that delaying Social Security is buying the best deferred annuity on the planet, allowing them to spend what they would have collected had they not delayed.
Now what if Blanchett and I are wrong in lowering the safe spend rate too much? Personally, I would rather have my clients come back to me saying they had too much money than telling me they are running out of money. The first problem is much easier to solve.